The first and foremost interest of a founder is to secure his interest. His interest is to help the company grow and create a market presence. Tag along and Drag along clauses of the shareholder’s agreement include provisions with regard to a possible transfer of shares or holdings. These are contractual obligations generally included in the articles of association or a shareholders agreement. A tag-along provision also known as the “co-sale right” is a clause that allows minor shareholders to “tag-along” with the larger group of shareholders if they find a buyer of their shares. A drag-along clause allows majority shareholders to pursue the minority shareholders to join on the sale of their shares. These clauses coordinate and balance the relationship between majority and minority shareholders in the event of a sale of shares. Therefore, these mechanisms protect the rights and interests of the company’s shareholders.
Tag Along Clause
The objective of this right is to favour the liquidity of the minority partners. If this clause is not incorporated in the shareholders agreement, the majority shareholders may sell their controlling interest to a third party. The minority would therefore remain with a stranger without having the option to sell their shares. This right allows minority shareholders to accompany the sale, then majority shareholders are persuing. They tag along when another shareholder receives an offer at the same price, terms and consideration. Large shareholders such as venture capital firms have the ability to source better buyers and negotiate the most profitable payment terms. Therefore, this clause provides greater liquidity to the minority shareholders. Private equity shares are extremely hard to sell, but majority stakeholders can facilitate sakes on the secondary market.
The flip side of this coin is that this clause may discourage majority shareholders from investing in the company. After all, these right forces company’s management and large shareholders to work out, negotiate and make concessions that will profit the minority shareholders. In other words, some investors will not choose a company that makes less than favorable obligations for them.
Drag Along Clause
This clause gives the majority shareholders a right to drag along the minority shareholders to sell their shares and ownership to a potential buyer. Therefore, the minority is left with no other option but to comply. This provision requires that the price, terms and conditions of the share sale be homogeneous across the board, signifying that small equity holders can realize favourable sales terms that he may otherwise not attain. From the perspective of majority shareholders, this clause 2 primary advantages- Firstly it increases the marketability of the investee business by delivering the target company without any minority interest(purchasers may be unwilling to participate in the sale with a minute number of shareholders with differing interest).
Secondly it potentially secures a higher “premium for control” share valuation by providing the entire interest in the target company to the prospective buyer. (as opposed to only a partial stake)
Example of this rights-
This is a real-life example – In 2019 Bristol-Myers Squib Company and Celgene Corporation entered into a merger, following which Squib acquired Celgene in a cash and stock transaction valued at $74 billion. After acquisition Squib accounted for 69% of the shares and Celgene for the remaining 31%. Celgene’s minority shareholders were not permitted of any special options and were forced to compel with the receipt of one Squib share and $50 for each Celgene share owned.
The Celgene shares were delisted in this deal. In the above example you can infer that the minority shareholders were required to comply with the terms and conditions of the deal and were not qualified for any special considerations. Had there been drag and tag along clause, the situation could have been different. In situations like these the majority shareholders can negotiate special share rights under an alternative class structure that may not be available to minority shareholders due to the implications of drag along rights.
Need for these clauses
The tag along clause –
- Protects minority in case the majority does not utilize or exercise their drag along rights – if you are in the minority, you do not have to be left behind if majority shareholder decides to exit.
- Provides liquidity and exit route for minority shareholders- if the minority shareholder owns 10% of the shares, he might have to sell his shares at a price lower than the actual price because of the absence of liquidity.
The drag along clause –
- This is generally designed for the majority shareholders, especially in the event when the buyers are looking for the complete control of the company.
- Drag along allows the elimination of minority shareholders and sell 100% of the company shares smoothly to a potential buyer.
These clauses balance each other out and are complementary. If one is included, the other should also be incorporated.
When are these rights triggered?
Drag along and Tag along rights are triggered in numerous transactions like mergers and acquisitions, takeover or change in control of the firm in any form. The majority shareholders agreement percentage may vary between 51% – 75% of the shareholding.
In light of the above analysis, we can infer that these rights are exclusive and special rights included in the contract. These rights are formulated to protect the exit options of either the majority shareholders in the form of drag along and minority shareholders in the form of tag along rights. These rights should be worked out in the contract only after considering each and every possible factor. Moreover, the legal application of these rights is clear and explicit in India. The AoA of a private limited company must allow the execution of these rights, whereas in a public company, the transaction must be in good faith and beneficial to the users of the company.